Proposed AIFM Directive

Practical Law UK Articles 1-503-6376 (Approx. 12 pages)

Proposed AIFM Directive

by Neil Robson, Christopher Hilditch and Josh Dambacher, Schulte Roth & Zabel LLP

Drafts of the AIFM Directive

There are four principal drafts of the AIFM Directive:

Commission Draft of 30 April 2009 (http://ec.europa.eu/internal_market/investment/docs/alternative_investments/fund_managers_proposal_en.pdf).
Parliament Draft (www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+COMPARL+PE-438.149+03+DOC+PDF+V0//EN&language=EN).
Council Draft (http://register.consilium.europa.eu/pdf/en/10/st06/st06795-re03.en10.pdf).
Latest Belgian compromise proposal (of 13 October 2010) (http://register.consilium.europa.eu/pdf/en/10/st14/st14737-re01.en10.pdf).

Scope

It is proposed that the AIFM Directive will apply to:

All EU AIFMs managing one or more AIFs, irrespective of whether the AIF is based in the EU.
All non-EU AIFMs which manage one or more EU AIFs.
All non-EU AIFMs marketing one or more AIFs in the EU, irrespective of whether the relevant AIF is an EU AIF or a non-EU AIF.

It is not significant whether the AIF is open-ended or closed-ended, or whether the AIF is a body corporate or a trust. If the AIFM is within the scope of the AIFM Directive, its provisions apply.

AIFM

The AIFM Directive stipulates that an AIF can have only a single AIFM (although it will not always be clear which party is the AIFM, particularly where there may be a manager offshore and an onshore delegate (or sub-adviser), as in the model used by much of the European hedge fund industry).

A "self-managed" fund (where the governing body does not appoint an external AIFM) will itself be the AIFM.

The Parliament text states that the AIFM is "the person whose business is to manage AIF". The Council's draft and the Belgian compromise proposal state that where an external manager is appointed, the AIFM is the person appointed by (or on behalf of) the AIF. If a manager is simply a delegate of the actual manager appointed by the AIF (for example, a sub-adviser), it is not the AIFM. An AIFM managing an AIF is not deemed to be providing portfolio management services under Directive 2004/39/EC on markets in financial instruments (Markets in Financial Instruments Directive) (MiFID) and instead will be providing AIFM Directive collective portfolio management. The implications of this distinction are not yet entirely clear, although as the AIFM Directive seeks to regulate managers of relevant "collective investment undertakings," the AIFM Directive would not appear to regulate those managers which only manage segregated managed accounts for individual clients.

Authorisation

Where an AIFM is within scope, it will be required by the AIFM Directive to become authorised by the financial regulator in its home state. The application process is likely to include detailed information concerning:

The AIFM owners.
The AIFM activities.
The AIFs that the AIFM intends to manage.
Any delegation of management services to third parties.
Any arrangements made for the safe-keeping of AIF assets.

Exemptions

The AIFM Directive provides certain exemptions from authorisation for AIFMs that directly or indirectly manage AIFs with aggregate assets (including assets acquired by leverage) of less than:

EUR100 million (as at 1 November 2010, US$1 was about EUR0.7).
EUR500 million if the funds managed do not:
- use leverage; or
- grant redemption rights for the AIF's initial five years.

This second exception will provide limited relief to AIFMs of private equity funds and other similar closed-ended funds. However, the AIFM Directive does not indicate how the de minimis exceptions will be measured, given that the value of fund assets fluctuates over time. There is also an exemption from authorisation for EU-domiciled AIFMs which do not manage AIFs domiciled in the EU and do not market AIFs in the EU. A further exemption would allow EU "credit institutions" (that is, banks (and indirectly the AIFs they manage)) to avoid the requirements of the AIFM Directive, despite the fact that in many instances they would be conducting identical activities.

Capital requirements

The AIFM Directive requires authorised AIFMs to maintain a minimum capitalisation of EUR125,000, although where aggregate net assets under management (AUM) exceed EUR250 million, an additional amount of "own funds" equal to 0.02% of the amount by which the net AUM exceeds EUR250 million must also be maintained (subject to a maximum own funds amount of EUR10 million). In determining the aggregate net AUM, AIFMs must include the net assets of AIFs:

Which the AIFM manages directly.
Which the AIFM manages by delegation.
For which the AIFM has itself delegated management authority to a third party.

Although the Council text of the AIFM Directive imposes no restrictions on the way in which initial capital or own funds could be invested, the Parliament text and the Belgian compromise proposal require that they must be invested in liquid assets or assets readily convertible to cash in the short term. The Belgian proposals would also prohibit investment of these funds in speculative positions. The Parliament and Belgian proposals are significant as the restriction would prevent AIFMs from using these funds as working capital and could be a significant cost factor for new AIFMs wishing to establish in the EU.

Significantly, the Parliament proposals (unlike the Council text or the Belgian compromise) would also require that an AIFM invest in every AIF it manages, so that the AIFM has an economic exposure greater than or equal to a set percentage of the total amount invested by other investors. The relevant percentage is not specified in the Parliament's draft.

In addition, the AIFM Directive does not require a minimum capitalisation for AIFs.

Valuation

The AIFM Directive requires authorised AIFMs to appoint an independent external valuer (or "valuator" in the terminology of the original Commission draft) for each AIF it manages, to value the assets and the shares of the AIFs. Valuations must be performed and published at least once a year and each time shares are issued or redeemed. The AIFM Directive also requires authorised AIFMs to ensure the valuer has appropriate and consistent procedures for the valuation of assets.

The AIFM Directive's valuation requirements apply to all AIFs managed by an authorised AIFM including private equity funds, for which these valuations may not be particularly relevant or easy to obtain. As a result, the AIFM Directive may result in valuations being performed by a valuer that knows less about the asset being valued than the AIFM, for which there is little benefit, if any, to investors.

An authorised AIFM must notify the appointment of the external valuer to its home regulator and must be able to demonstrate that the valuer is subject to mandatory professional registration.

Depositary

The AIFM Directive requires authorised AIFMs to appoint an independent "depositary" (that is, a custodian) for each AIF that it manages, to:

Receive and book subscription payments.
Safe-keep the financial instruments of the AIF.
Verify ownership of all other AIF assets.

The depositary must act solely in the interest of AIF investors, which requires the depositary to take on broader functions than a traditional custodian or prime broker. This raises questions about whether re-hypothecation of assets will continue to be possible under the AIFM Directive.

Similarly to the independent valuer requirements, the AIFM Directive's depositary requirements apply to all AIFs managed by an authorised AIFM, including private equity funds. Given that some existing AIFs may require investor consent to engage a new depositary, some managers may not be able to comply with the depositary requirements for AIFs that they currently manage.

Categories of depositary

The EU authorities have agreed that an AIFM cannot be a depositary, but differ concerning which entities can be a depositary.

Parliament proposals. Parliament would only permit those persons satisfying the following criteria to act as depositary:

They are authorised by the AIFM's home regulator.
They are subject to prudential regulation and supervision equivalent to that for EU credit institutions (that is, banks).
They can provide sufficient financial and professional guarantees.

Council proposals. The Council would allow these persons and the following additional categories of persons to act as depositary:

Institutions which qualify as UCITS depositaries under Directive 2009/65/EC on undertakings for collective investment in transferable securities (UCITS IV Directive).
For unleveraged AIFs whose investors have no redemption rights for five years from the date of their initial investment, any entity:
- conducting depositary functions as part of professional or business activities in relation to which it is subject to:
  mandatory professional registration recognised by law; or
  legal or regulatory provisions or rules of professional conduct; and
- which can provide sufficient financial and professional guarantees.

In both cases, these persons must have regulatory approval in the EU country in which they are based or conducting business.

Belgian compromise. The Belgian compromise would allow the following categories of persons to act as a depositary for EU AIFs:

EU banks.
MiFID investment firms.
Institutions which qualify as UCITS depositaries under the UCITS IV Directive.

For non-EU AIFs, the depositary must be an equivalent entity in the AIF's jurisdiction authorised by its home regulator to conduct equivalent activities, or an entity in the home state of the AIFM. EU AIFs must have a depositary in their jurisdiction of establishment.

Limited delegation to sub-custodians

The Parliament text does not place a limit on the tasks that may be delegated by a depositary to another appropriately qualified depositary, other than to require that a depositary should not delegate its functions to the extent that it is simply a "letter-box". The Council text (and the Belgian compromise) only allow limited delegation, generally for the activities of safe-keeping of financial instruments belonging to the AIF, and/or verification of the AIF's ownership of investments. However, the Council text would require the depositary to show that it has an objective reason for delegating, and the depositary must supervise the delegate to ensure it satisfies conditions relating to supervision, systems and controls, audit and the segregation of assets.

The current reality is that custodians generally appoint sub-custodians in the country in which the issuer of a security is incorporated and, in some jurisdictions, title to securities must be held by a local sub-custodian. As a result, the limits the AIFM Directive places on the depositary's domicile and its ability to delegate to sub-custodians could restrict the availability of certain assets to AIFs managed by an authorised AIFM. This will make it more difficult for an AIF managed by an authorised AIFM to appoint multiple custodians, leading to an increased concentration of counter-party risk.

Liability of depositary

Under the AIFM Directive, the depositary will assume a (quasi-)strict liability standard in relation to custody of an AIF's assets, which will almost certainly reduce the number of institutions willing to provide depositary services. If any institutions are willing to provide these services, the cost of these services for AIFs managed by authorised AIFMs will increase. Specifically, the depositary would be directly liable to both the AIF and/or its investors for any losses suffered as a result of failure by the depositary to perform its obligations. The depositary's liability is also unaffected by delegation to a sub-custodian and can only be avoided if the depositary can prove it could not have avoided the loss.

Transparency requirements

There are disclosure requirements to both regulators and investors, and to investors before investment takes place.

Disclosure to regulators and investors

The AIFM Directive requires an authorised AIFM to provide a minimum level of disclosure on each AIF that it manages and/or markets in the EU in the form of an annual report for each AIF for each financial year. The annual report must be provided to investors on request and must be made available to the AIFM's home state regulator and, where applicable, the regulator of the EU home state of the AIF. The annual report must contain, as a minimum:

A balance-sheet or a statement of assets and liabilities.
An income and expenditure account for the financial year.
A report on the activities of the financial year.
An indication of how the changes in the information during the financial year covered by the report are made available.
The total amount of remuneration for the financial year, split into fixed and variable remuneration paid by the AIFM, the number of beneficiaries and, where relevant, carried interests paid by the AIF.
The aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.

Disclosure to investors pre-investment

An AIFM would also be required, for each of the EU AIFs that it manages and for each AIF it markets in the EU, to make available to AIF investors an extensive list of informational requirements before they invest in the AIF, as well as any changes to this information. The list includes items such as:

A description of the AIF's investment strategy and objectives.
Information on where any AIF is established (and information on where underlying funds are established if the AIF is a fund of funds).
The types of assets which the AIF may invest in, the techniques it may employ and all associated risks.
Applicable investment restrictions.
The circumstances in which the AIF may use leverage and the types and sources of leverage permitted, and the associated risks.
A description of the procedures by which the AIF may change its investment strategy or investment policy, or both.
A description of how the AIFM is complying with initial capital and own funds requirements.
A description of the AIF's valuation procedure and of the pricing methodology for valuing assets.
A description of all fees, charges and expenses and of the maximum amounts of these which are directly or indirectly borne by investors.
How the AIFM ensures a fair treatment of investors and, whenever an investor obtains a preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment. This should also include the type of investors who obtain the preferential treatment as well as, where relevant, their legal or economic links with the AIF or AIFM.
A description of any material arrangement of the AIF with its prime brokers and the way the relevant conflicts of interests are managed.

This entails a very long list of disclosures and many of the required disclosures would be part of a well-drafted offering document. It is difficult to understand how this information will be useful to most investors.

Leverage

The Commission's initial draft of the AIFM Directive would have imposed leverage limits on AIFs managed by authorised AIFMs to ensure the stability and integrity of the financial system. In setting limits on leverage, the Commission would take into account the type of AIF, its strategy and sources of leverage. The AIFM Directive would also give EU regulators the power to impose additional temporary limits on leverage in exceptional circumstances to ensure the stability and integrity of the financial system.

The Belgian compromise proposal involves:

Removing leverage limits generally, but giving EU regulators the power to impose additional temporary limits on leverage in exceptional circumstances.
Requiring EU regulators to gather and share (with other relevant EU regulators) data on leverage.
Allowing regulators to impose temporary leverage limits on an AIF or AIFM where leverage is deemed to be excessive, and therefore presenting a risk to the stability and integrity of the financial system (any limits would have to be notified to the European Securities and Markets Authority (ESMA) to ensure EU supervisory co-operation).

The Commission's initial draft of the AIFM Directive also required authorised AIFMs managing AIFs employing a high level of leverage on a systematic basis (that is, where the AIF's leverage exceeds the value of its equity capital in two of the previous four quarters) to disclose to investors:

The maximum level of leverage.
Any rights granted in relation to the re-use of collateral.
On a quarterly basis, the total amount of leverage employed by the AIF in the preceding quarter.

These AIFMs would also be required to regularly disclose to their regulator the level and type of leverage employed, and the identity of the five largest sources of borrowed cash and securities for each AIF managed.

Marketing

One of the most contested elements of the AIFM Directive in the trialogue discussions has been the Commission's proposals for a pan-European marketing regime for AIFs managed by authorised AIFMs. The original draft of the AIFM Directive would have allowed authorised AIFMs to market the AIFs they manage to professional investors throughout the EU, thereby allowing these AIFs to avoid the country-specific private placement regimes (many of which severely limit or prohibit the offer and sale of investment funds). However, in developing the Commission's initial draft of the AIFM Directive, the Parliament and the Council have each taken different approaches to the rules applying to non-EU countries (third countries) and the way in which third-country AIFs may be permitted to be marketed to investors in the EU.

Parliament proposals

The Parliament's proposals include the following:

EU investors could only invest in an AIF that is eligible for a "passport" under the AIFM Directive. This means that non-EU AIFs would have to comply with the majority of the AIFM Directive.
AIFs established in third countries would only be able to qualify for a passport if they satisfied four "qualitative criteria":
- there must be a co-operation agreement between the AIF's jurisdiction's regulator and the regulator of the EU country into which the AIF is to be marketed;
- the jurisdiction in which the AIF is established must be proven to comply with Financial Action Task Force requirements on money laundering and terrorist financing;
- there must be a tax information exchange agreement, compliant with the Organisation for Economic Co-operation and Development (OECD) requirements, between the AIF's domicile and the EU country into which the AIF is to be marketed;
- there should be an equivalence of access for EU AIFs to the markets in the jurisdiction where the AIF is established.

Council proposals

EU-based AIFMs would be required to comply with the AIFM Directive, irrespective of where their AIFs are established, based on the following:

If they are managing EU-based AIFs they would be able to benefit from a passporting regime.
If they manage AIFs established in a third country, these AIFs would only be permitted to be distributed under each EU jurisdiction's private placement regime provided that both:
- a co-operation agreement is in place between the regulators of the third country and the regulator supervising the relevant EU-based AIFM;
- the AIFM complies with the provisions of the AIFM Directive (excluding the requirements on annual reports and depositaries).
Third-country AIFMs would be able to distribute their AIFs (wherever established) into the EU using national private placement regimes. However, this would only be possible if both:
- the AIFM complies with the reporting and disclosure obligations set out in the AIFM Directive;
- a co-operation agreement is in place between the AIFM's third-country regulator and the regulator of the EU country in which the AIF is to be distributed. In this scenario, there would be no applicable passporting regime. Each third-country AIFM must interact with the regulators in each country of the EU in which they wish to do business.

Belgian compromise proposals

The Belgian compromise proposals consist of the following:

EU investors could only invest in AIFs that comply with the AIFM Directive (and thereby qualify for a passport).
Third-country AIFs that are to be distributed in the EU would have to comply with the AIFM Directive (and so would also thereby qualify for a passport). To do so, the non-EU country of domicile of the AIF would also have to satisfy the following qualitative criteria, irrespective of whether the AIF is being marketed in the EU by an EU AIFM or a third-country AIFM:
- there should be appropriate co-operation arrangements in place between the regulators of the home EU country of the AIFM, the host EU countries of the AIFM and the supervisory authorities of the third country where the non-EU AIF is established;
- the third country where the non-EU AIF is established must not be listed as a Non-Co-operative Country and Territory by the Financial Action Task Force on anti-money laundering and terrorist financing.

The Belgian compromise also proposes that where marketing is being conducted by a third-country AIFM, that AIFM would also have to comply with the AIFM Directive. For such a third country AIFM to market in the EU, an EU "member state (MS) of reference" would have to be designated and the third-country AIFM registered with or authorised by the regulator of that MS of reference, before the third-country AIFM could conduct marketing activities in the EU. The determination of this MS of reference would be determined by the regulator of the main EU jurisdiction in which the third-country AIFM conducts most of its EU activities (although how this is to be measured is unclear). If the third-country AIFM manages at least one EU AIF, its MS of reference would be the home MS of the AIF and the regulator of this MS would be competent for the authorisation procedure and the AIFM's supervision.

If the AIFM manages AIFs established in different MSs, the MS of reference would be the MS where most of the AIFs are established or the MS where the largest amount of assets is being managed. If the third-country AIFM markets at least one third-country AIF and does not manage any EU AIF, the MS of reference would be the MS where the third-country AIFM intends to develop "effective marketing" (proved by its marketing strategy) (the meaning of this term is not yet clear). If the third-country AIFM will effectively market one AIF in different MSs, it could choose its MS of reference among those MSs. If the AIFM markets several third-country AIFs, it must choose the MS where it intends to develop a marketing strategy for most of those AIFs.

The Belgian proposals envisage that after the AIFM Directive comes into force across the EU (potentially at the end of 2012), there would then be a transitional period of two years for the development of the passport regime during which EU countries would be permitted to maintain their existing private placement regimes in parallel with the passport regime (that is, a dual regime for marketing would exist, with either the passport being used or the local private placement exemptions). At the end of this two-year period (that is, potentially at the end of 2014) ESMA would then be required to issue the Commission, Parliament and the Council with an opinion on:

The functioning of the EU passport for EU AIFMs marketing non-EU AIFs in the EU, and non-EU AIFMs managing and/or marketing AIFs in the EU.
The functioning of the marketing of non-EU AIFs by EU AIFMs in the EU.

ESMA's opinion would not be binding on the Commission, Parliament or the Council. However, if the opinion were to state that the passport is effective and that there was no longer any need for private placement regimes to exist in parallel with the passport, the final result could be the abolition of all private placement regimes across the EU three years later (that is potentially at the end of 2017). This would significantly change the existing practice of marketing funds under the existing country-specific private placement regimes and instead allow authorised AIFMs to market the AIFs they manage to professional investors on a pan-European basis (including in those EU countries that currently prohibit marketing of these AIFs).

While the passporting regime may sound like a major benefit to the EU AIF industry, the practicalities or difficulties of using the passport will determine how widely the national private placement regimes continue to be used and whether they will survive or if the passport will become the sole means of marketing AIFs in the EU.

Remuneration

In November 2009, the Swedish Presidency added an annex to the draft AIFM Directive with remuneration principles similar to those in the drafting of the November 2009 proposal for the Capital Requirements Directive (known as CRD3). The principles propose that remuneration policies must be established for AIFM staff whose professional activities have a material impact on the risk profile of the AIFM, or on the AIFs that it manages. The text of CRD3 was agreed by the EU in early July 2010 and its remuneration provisions will come into force across the EU on 1 January 2011. The intention of the EU is to harmonise, across the EU's financial sector, remuneration policies that are consistent with effective risk management. Given that the text of CRD3 has been approved at EU level, it seems likely that there will be a high degree of overlap between the CRD3 remuneration regime and the AIFM Directive's proposed remuneration regime once the final text is agreed. However, it is possible that the final AIFM Directive rules on remuneration may contain a degree of flexibility to allow EU regulators discretion in implementing the AIFM Directive's remuneration provisions. At the final trialogue meeting before the summer recess, the parties agreed that the text should be aligned with the wording of the CRD3 text and would allow some rules to become core provisions (applicable to all firms) and other rules to be applied on a proportionate basis. These proportionality provisions have been included within the Belgian Presidency's compromise text. However, remuneration is one of the areas of the AIFM Directive where there is likely to be a great deal more change before the AIFM Directive is finalised.

For categories of staff, including senior management, whose professional activities have a material impact on the risk profiles of AIFs they manage, the proposed rules would require AIFMs to have remuneration policies and practices that:

Are consistent with and promote sound and effective risk management.
Do not encourage risk-taking which is inconsistent with the risk profiles, fund rules or instruments of incorporation of the AIF it manages.

Some of the detail of the proposed remuneration rules includes:

Where remuneration is performance related, the total amount of remuneration should be based on a combination of the assessment of the performance of the individual and of the business unit or AIF concerned, and of the overall results of the AIFM. When assessing individual performance, financial as well as non-financial criteria are to be taken into account.
The assessment of performance should be set in a multi-year framework appropriate to the life-cycle of the AIF.
Fixed and variable components of total remuneration should be appropriately balanced. The fixed component should represent a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component.
Subject to the legal structure of the AIF and its instruments of incorporation or fund rules, at least 50% of any variable remuneration should consist of units or shares of the AIF concerned, equivalent ownership interests, or share-linked instruments or equivalent non-cash instruments.
At least 40% of variable remuneration should be deferred for three to five years (unless the life cycle of the AIF concerned is shorter).
Remuneration payable under deferral arrangements should vest no faster than on a pro rata basis. In the case of a variable remuneration component of a particularly high amount, at least 60% of the amount should be deferred.
The variable remuneration, including the deferred portion, should be paid or vest only if it is sustainable according to the financial situation of the AIFM as a whole, and must be justified according to the performance of the business unit, the AIF and the individual concerned.
The total variable remuneration should generally be considerably contracted where subdued or negative financial performance of the AIFM or of the AIF concerned occurs (taking into account both current compensation and reductions in payouts of amounts previously earned, including through clawback arrangements).

These proposals raise many questions. For example, it is not clear if:

Carried interest would be included within the definition of remuneration.
Profit shares paid by AIFMs established as limited liability partnerships (as is often the case in the UK) would be covered (since partnership profits are the return on capital invested in a business, they are not a bonus or remuneration).

The deferral rules also raise questions about measures that could be taken to mitigate the potentially adverse consequence of immediate taxation of this deferred income. There are currently no clear answers to these questions.

Further debate in the EU trialogue process is likely to progress many of the contentious areas of the AIFM Directive and it is possible that consensus will not be reached on the more heavily debated topics. For further information on the progress of the AIFM Directive, see Practice note: Hot topics: The AIFM Directive.

Contributor details

Neil Robson

Schulte Roth & Zabel International LLP

T +44 20 7081 8037F +44 20 7081 8010E [email protected]W www.srz.com

Qualified. England and Wales

Areas of practice. Regulatory and compliance.

Christopher Hilditch

Schulte Roth & Zabel International LLP

T +44 20 7081 8002F +44 20 7081 8010E [email protected]W www.srz.com

Qualified. England and Wales

Areas of practice. Investment funds; financial services; and corporate.

Josh Dambacher

Schulte Roth & Zabel International LLP

T +44 20 7081 8044F +44 20 7081 8010E [email protected]W www.srz.com

Qualified. New York

Areas of practice. Investment funds; financial services; and corporate.

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